October 16, 2002

Patrick Cunningham and Jeffrey Herrmann of Exeter

S&P Rank: 3 StarsSurvival of the Fittest Sto

Quick Take:Funds that invest in undervalued stocks of big companies have performed better than the overall stock market so far this year, although not by much. That's true of Exeter Fund:Maximum Horizon Series/A (EXHAX), too, which searches for stocks of companies with staying power.

The fund lost 26.1% for the nine months ended in September, but that put it ahead of the Standard & Poor's 500-stock index, which fell 28.2%. In comparison, the Exeter Maximum Horizon's large-cap value fund peers were off 25.7% during the period.

The Full Interview:

When analyzing stocks in cyclical industries, the team that oversees the Exeter Maximum Horizon Fund borrows from Charles Darwin. The managers search for businesses they see as most likely to outlast a downturn in a sector and to lead the recovery when conditions improve.

"We're trying to buy the survivors," says Jeffrey Herrmann, who helps run the portfolio. "One way to think of it is: I want to be the guy driving the cement mixer at the demolition derby."

In a similar vein, the managers look for businesses that dominate their fields and that have some sort of sustainable competitive edge, like patents or well-known brands. They lean towards inexpensive stocks of companies with growing earnings.

The team also hunts for companies whose stock price does not appear to fully reflect the value of their underlying assets and cash flow. Within this group, the managers then look for a catalyst that can boost a stock, like new management or a restructuring.

The approximately $60-million fund concentrates on large and mid-sized companies and typically owns 45-55 stocks.

A recent addition to the portfolio is toy and game maker Hasbro Inc (HAS). The company stands out, Herrmann says, because it and Mattel, Inc (MAT) are the two biggest players in their field. Hasbro also generates loads of free cash, but doesn't have to plow a lot of it back into the business, in part because it contracts out manufacturing, Herrmann notes. That leaves money available to pay dividends or buy back stock, he says.

The managers began buying Hasbro three weeks ago. Their shares cost $11 on average. The stock closed at $11.17 today.

Among companies in troubled industries, the team have been investing in aluminium producer Alcoa Inc (AA) lately. Although aluminium prices have been depressed and the industry has been suffering from excess smelting capacity, the managers say, they expect Alcoa to prosper because it is one of the lowest cost manufacturers in the industry. They also like Alcoa's global presence.

The managers started investing in the Pittsburgh-based company in September, paying $19-$20 per share, on average. The stock closed at $19.11 today.

Herrmann says the team has been finding the kind of cheap stocks it prefers among health care companies, including drug makers, which now account for just over 20% of the fund's assets. Valuations in the sector, compared to the market and the stocks' own histories, are lower than they have been since the early 1990s, according to Herrmann.

The team bought a stake in pharmaceuticals manufacturer Merck & Co (MRK) about five months ago. Although the stock has fallen since the initial investment, the managers say they are optimistic about the company's long-term prospects because of its strength in drugs to control cholesterol, as well as potential new products in its pipeline, such as a new anti-depressant.

The fund's shares of the drug giant cost about $50 on average. They closed at $44.26 today.

Merck has been working with Schering-Plough (SGP), another relatively new holding for the fund, to develop a new cholesterol drug that the managers say they believe has the potential to become a leader.

Schering-Plough's stock has fallen over the last three days, partly because the company warned today that earnings in each of the next two years would lag forecasts.

However, Patrick Cunningham, another member of the fund's management team, thinks investors have overreacted to the company's problems. The team, he says, thinks Schering-Plough's bottom line can grow by at least 20% in 2004 and increase again over the following two years as new products are debuted.

The managers added to their stake in Schering-Plough in April. They paid about $30 per share, on average. The stock closed at $17.30 today.

The No. 1 stock in the portfolio is another drug maker, Bristol-Myers Squibb (BMY). The company's attributes include a dividend yield of about 5%, the managers say. Also, they believe the company can generate earnings growth in the mid-teens over the next three to five years.

Companies that produce staple consumer products make up about 15% of the fund's portfolio. The managers say they like these businesses because they feature strong brands as well as predictable, increasing profits.

The fund's top holdings include Kimberly-Clark (KMB), the maker of Kleenex tissues and Huggies disposable diapers; and Unilever ADR (UL), which produces Ben & Jerry's ice cream and Lipton tea.

Exeter Maximum Horizon also owns PepsiCo Inc (PEP), which the managers began buying about two months ago. Its Frito-Lay product line, which controls a big piece of the fast-growing snack food line, makes the company attractive, Herrmann says. "It's an asset like no other asset in the world," he says.

The fund's PepsiCo shares cost about $36 on average. They closed at $37 today.

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